The answer most economists would give was that they were aware of credit-driven property booms around the world. They were aware of other excesses, like the fact that at one stage it seemed that every reasonably sized business seemed at risk of being taken over by private equity firms. They were aware, and had been for a quarter of a century, about global economic imbalances. But nobody could credibly say that these things would unwind in a way that would so catastrophic for the banks and the economy.
Things are getting better now but for the six months between October 2008 and April 2009, the economy was falling off a cliff. So what does one say to the Queen? I started, as many people did, by thinking about sub prime losses on mortgages (for people with no income, no job and no assets), essentially short-term effects. Gradually, however, I came to recognise that the forces that caused the crisis built up over many decades and continue to present a fundamental challenge.
The first challenge is for policymakers. It is clear policymakers, particularly central banks, were obsessed with fighting inflation, which was the problem of the 1970s and 1980s, and ignoring a much bigger danger. But it was also the case was that they were pretty good at dealing with crises.
Indeed, one of the reasons for the big crisis was the response of policymakers, particularly through aggressive cuts in interest rates, to a series of smaller crises. That success not only bred confidence that nothing really nasty could happen but also encouraged even faster credit growth.
But what do you do as a policymaker? All financial crises look quite serious when they start. The public would not look kindly on a policymaker who stood by while things got really nasty or, as Mervyn King, the Bank of England Governor did, preached moral hazard. The lesson should be that some crises should be allowed to run their course. In practice, that is never going to happen.
The other issue is the banks themselves. Will regulators ever be able to get to grips with the complexity of products and innovations the banks invent? Will bank boards, particularly non-executive directors, ever do so? So we are relying on the banks to be sensible, which they may be for a while, and then they will start not being sensible again and, while it may not be for a long time, we will eventually have another crisis. It will not happen soon, and it will not be the same as the last crisis, but it will happen one day.
Some people argue we should leave the banks to it and let them fail. Maybe, but despite all the talk of living wills and orderly wind-downs, it is still the case that, for confidence reasons as much as anything else, even small banks are usually too big to fail.
The crisis also exposed just how thin the veneer of apparent consensus among economists was. As soon as the trouble started, economists were at each others’ throats, exposing fault lines every bit as real as those between the monetarists and Keynesians 30 or 40 years ago. It will take a while before anybody talks about a macroeconomic consensus again.
What will change as a result of the crisis? Already we are seeing the consequences of private debt obligations being transferred to the public sector, with consequences for sovereign debt, and intense pressure for fiscal consolidation. Countries, particularly in the euro zone, are adopting restrictive fiscal measures of a kind they never expected to do.
In the UK the public sector is heading for the biggest squeeze we have seen in decades, possibly since the 1920s. The good news is that this comes on the back of a decade of sustained expansion, so there is fat to be cut. The bad news is that even cutting fat is far from painless, so it will be tough. The fiscal consequences of the crisis will be with us for many years. Before it, UK government debt was limited to 40 % of GDP, and that was one of the government’s fiscal rules. Now it is rising fast and on plausible assumptions involving tax hikes and spending cuts, it will take until the 2030s to get back to 40%.
There is also the question of attitudes to markets more generally. We have been through a long period when the markets appeared to offer the solution to everything, not just financial markets, though governments were unusually in awe of them, but also markets more generally. Market solutions, whether in health, education, or other areas, were favoured. The crisis may have changed that. Before his election defeat Gordon Brown took to criticising “the Conservative idea that markets always self-correct and never self-destruct.” Not all politicians have caught up with this, particularly on the Tory side, but voters will be suspicious of markets, and market solutions, for some considerable time.
In 2007, just before the crisis there was an expectation that China would overtake Japan in about 2015 and America in about the 2030s. Now the expectation is that this will happen this year in the case of Japan and in the 2020s in the case of America. Last year, when advanced economies suffered their biggest post-war declines, China grew by nearly 9%, India by around 6%. Advanced economies are hobbled by their banking systems and the public finances, emerging economies less so. The crisis brought forward the shift to China and India by five-10 years. Has this been a big, world-changing event? In this and very many other respects, yes.
